Monday, February 9, 2009

Excellent summary of the origins of this crisis

John B. Taylor, an excellent economist and clear thinker, has a very good article in today's WSJ, entitled "How Government Created the Financial Crisis." With luck his message won't be drowned out by all the hand-wringing in Congress about how markets and capitalism have failed us and only a massive expansion of government can save us. As Taylor points out, correctly identifying the problems we face is essential to any solution. The stimulus bill assumes that the problem we face today is a shortage of demand, and prescribes mega-spending to cure the problem. Instead, it appears to me that we are still dealing with the consequences of the housing bust and the intense fear of counterparty risk that arrived in its wake. We can only hope that Geithner's plan, to be announced tomorrow, will address this problem effectively. And if we are lucky, public disapproval of the faux-stimulus plan may yet kill it before it has a chance to damage the economy.

Here are some excerpts from the article, but you really should read the whole thing:
My research shows that government actions and interventions -- not any inherent failure or instability of the private economy -- caused, prolonged and dramatically worsened the crisis.

Monetary excesses were the main cause of the (housing) boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience.

The effects of the boom and bust were amplified by several complicating factors including the use of subprime and adjustable-rate mortgages, which led to excessive risk taking.
Adjustable-rate, subprime and other mortgages were packed into mortgage-backed securities of great complexity. Rating agencies underestimated the risk of these securities, either because of a lack of competition, poor accountability, or most likely the inherent difficulty in assessing risk due to the complexity.

The government-sponsored enterprises Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with the risky subprime mortgages.

Early on, policy makers misdiagnosed the crisis as one of liquidity, and prescribed the wrong treatment.

Another early policy response was the Economic Stimulus Act of 2008. But people spent little if anything of the temporary rebate (as predicted by Milton Friedman's permanent income theory ...).

A third policy response was the very sharp reduction in the target federal-funds rate to 2% in April 2008 from 5.25% in August 2007. The most noticeable effect of this rate cut was a sharp depreciation of the dollar and a large increase in oil prices. After the start of the crisis, oil prices doubled to over $140 in July 2008.

After a year of such mistaken prescriptions, the crisis suddenly worsened in September and October 2008. ... on Tuesday, Sept. 23, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson ... introduced the Troubled Asset Relief Program (TARP), saying that it would be $700 billion in size. A short draft of legislation was provided, with no mention of oversight and few restrictions on the use of the funds.

The two men were questioned intensely and the reaction was quite negative, judging by the large volume of critical mail received by many members of Congress. It was following this testimony that one really begins to see the crisis deepening and interest rate spreads widening.

The realization by the public that the government's intervention plan had not been fully thought through, and the official story that the economy was tanking, likely led to the panic seen in the next few weeks. And this was likely amplified by the ad hoc decisions to support some financial institutions and not others and unclear, seemingly fear-based explanations of programs to address the crisis.


Mark A. Sadowski said...

I read John Taylor's article and I don't disagree in substance but I do in emphasis. My own opinions are aligned with Menzie Chinn who wrote the following on Christmas day (it was better than a present to me):

"So what I want to think about is the toxic mixture of the last five items, which interacted in a synergistic manner to place us in the situation we are now in.

First, monetary policy. While there seems to be a widespread consensus that it was too lax in 2002-04, this is a viewpoint made with the benefit of hindsight. As Orphanides and Wieland (2007) [pdf] have pointed out, according to the Greenbook forecasts, monetary policy was not -- according to a Taylor rule framework -- overly lax.

Second, deregulation. On this front, I think it's important to not indict all deregulation (eliminating the Glass-Steagall barriers makes sense to me, while the Phil Gramm-sponsored Commodity Futures Modernization Act exemption of regulation of CDS's does not). I outline some empirical research on what factors were important in this crisis in this post.

Third, regulatory disarmament/nonenforcement and "criminal activity". I would have discounted this item in the absence of clear evidence, but now that we know about how the OTS "helped out" IndyMac [2] [3], I think we can be reasonably confident that we'll hear a lot more about how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.

Fourth, fiscal profligacy via tax cuts. I think it's important to focus on profligacy (because it pushed the economy more into a boom exactly at a time when not needed) and on tax cuts (because it made people feel like they had more discretionary income than reasonable), thereby pushing the asset boom.

Fifth, tax policy. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (I've been thinking about this in part because mortgage deductibility on a second home never made sense to me, let alone on a first home). Capital Games and Gains has pointed out this provision, citing a NYT article. But even this last article doesn't locate primary blame here; rather it's cited as a contributing factor. I suspect that on its own, this provision wouldn't had a big impact, but in combination, it might have. My caveat here is that I haven't found much empirical work backing a big role for this factor.

Typically, in my academic work, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But (departing from a model, and with no econometric work to back up the hypothesis interactive effects), I think it's worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the "bubble" (in a nontechnical sense) we've witnessed, the deflation of which has been associated with the ongoing financial crisis.

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [9]; with regulatory oversight absent, and low interest rates, well the stage was set."

Scott Grannis said...

Mark: you are really dug in with the Keynesian analysis.

I think it preposterous to say that lowering tax rates (and letting people keep more of their money) could be a contributing factor to any economic disaster. The purpose of taxes is to fund government spending, not to regulate economic activity.

I think a lot of excellent observers have concluded that "deregulation" played no role in this mess. If anything it was a failure of existing regulations that was a problem. That goes back to government being the source of the crisis.

I would agree that tax deductibility of mortgage interest contributed to the crisis. This is a good example of how government policies were the source of the problem. Tax rates should be low and flat, and deductions should ideally be nonexistent.

Mark A. Sadowski said...

The issue of tax deductions is something we can both agree on (simpler is fairer and better economically). In fact I am extremely disturbed that a large tax credit for home purchases ($7500 and $15,000) is part of both stumulus bills (and both sides of the isle are guilty on this score). This is the kind of tax induced market distortion that got us into this pickle in the first place, and it is a mindless attempt at placing a price floor under the housing market (that is doomed to fail). Unfortunately I fear the real estate lobby is never going to let the mortgage interest tax deduction for first or second homes disappear.

Spiral said...

One government regulation that contributed to the financial crisis was the way the FDIC categorized and defined risk for member banks.

If a bank originated a 30 year mortgage and serviced that mortgage, this was considered by the FDIC a moderately risky asset, since the borrower could stop paying on the mortgage.

If, however, a bank decided to purchase mortgage backed securities with a AAA or AA rating, this was considered by the FDIC to be a low risk asset.

Banks were required to hold more capital reserves if they originated their own mortgages than if they purchased mortgaged backed securities backed by mortgages originated by mortgage brokers.

I remember when I got my home re-financed in 2003. My mortgage broker told me that I could get the Private Mortgage Insurance (PMI) removed if the house appraised for 300,000 dollars because I only owed about 240,000 on my mortgage. I would have 20 percent equity and would no longer have to pay PMI.

My house got appraised for......

.... you guessed it: 300,000 dollars.

And this was even though a house two doors down that had a finished basement (our house had an unfinished basement) sold recently for 298,000 dollars.

But the mortgage broker and the appraiser didn't care. The mortgage broker knew he was going to sell the mortgage to a big bank and let them deal with the risk of default or delinquency.

So, the FDIC encouraged banks to purchase anonymous MBS where they were at an informational disadvantage instead of originating their own mortages where they would do their own appraisals.

Regulations usually don't accomplish their goal of protecting banks from their own bad business model. Quite often it's just the opposite.

Scott Grannis said...

Spiral: excellent point, thanks

Randy R said...

If I had to narrow the collapse down to a single flaw, I would say it is the disconnect between those evaluating the risk and those bearing the risk. This seems to me the achilles heal in modern capitalism. This is manifested in:

1. Securitized risk sold to investors that have no practical way of analyzing it. Most obvious example is mortgage brokers that get paid for originating and servicing loans while securitizing the risk for the public. Hedge funds are another example.
2. CEO compensation plans that payoff insanely for success but allow them to walk (still enriched) and let shareholders (and now taxpayers) suffer the losses.

Other factors are obviously ingredients but the reason they came into play was that the “invisible hand” of capitalism could not self correct because of the disconnect of risk takers and bearers. For example, without regard to monetary policy, regulation, and tax policy - if bankers kept the loans they originated, and bank CEOs didn’t get outrageous compensation incentivizing outsized risks, how badly would they trash their lending standards.

I realize of course that derivatives and securitized risk have an immensely important role in legitimate risk management and sophisticated investing – efficient use of capital. I wish I had more time to flesh out those thoughts – no doubt my hurried comments are lacking.

Brian H said...

I've written letters to my Senators - I hope everyone else out there is doing the same. "Kill the Economic Euthanasia bill!"

Jon S. said...

Off topic somewhat, here's a great quote from an op-ed by George Melloan in today's WSJ, for those commenters who think all is peachy with the stimulus plan:

"Even when the economy and the securities markets are sluggish, the Fed's financing of big federal deficits can be inflationary. We learned that in the late 1970s, when the Fed's deficit financing sent the CPI up to an annual rate of almost 15%. That confounded the Keynesian theorists who believed then, as now, that federal spending "stimulus" would restore economic health."

Gene Prescott said...

Link is to WSJ post regarding President Obama's news conference:

Since perception is a factor in the economy, will the stimulus package have a 'jolt' in perception?

Scott Grannis said...

Gene: Listening to Obama and reading the details of the stimulus package, I would be surprised if the people in charge of large sums of money felt any better about the future after seeing this display of economic stupidity and this stimulus package which boils down to a partisan spending spree crafted by the clueless Nancy Pelosi.

I've thought all along that the prospect of just this sort of "stimulus" was one big factor keeping the market from rallying. I continue to believe that.

dave said...

Taylor is exactly right , the economy far from being inherently unstable, is when left alone self correcting. The problem is that Congress won't leave it alone.

John Tamny has a nice article on this today.

The fed doesn't finance the deficit the treasury sells bonds to finance the deficit. The Fed manages the money supply , their mismanagement of the money supply in the 70's is what led to the inflation we all experienced.

During WWII the US financed much larger deficits and did it at very low interest rates , because the value of the dollar was tied to gold and thus stable. Today the dollars value floats freely, so it is not just a matter of can the US make their interest payments but what will those payments be worth when they are received?

Jon S. said...

Dave -- I was quoting George Melloan, who was clearly writing 'short-hand' -- I'm sure he knows what the Fed does and what the Treasury does!

Scott Grannis said...

Prospero: your comments are certainly valid, but I'll stick with bad government policies as the origin of the disaster. The collapse of Fannie and Freddie ended up being so far beyond anyone's expectations or experience that any weak links in the market (complicated derivatives, etc.) then broke.

I don't fault CEOs too much, as only a handful of people out there had any idea of the magnitude of the impending disaster. If they received excessive pay, that is a problem for shareholders to resolve.